Multinational Cost of Capital - Literature review Example

Multinational Cost of Capital By + Introduction The globalization of firms is a common occurrence in the business world. Firms that operate in one nation state only are much more the exclusion of the internationalization rule (Baker 2011). Multinational companies are global organizations that dominate different industries in the world’s developed economies (Hitt 2004). Theoretical and empirical studies on the globalisation of firms and multinational companies have in spite of the relatively short period, reached a significant level. Financial facets of multinational firms have been discussed since the early 1970’s, a time when arguments on multinational enterprise and globalisation were still in infancy (Baker). However, an insight into research literature reveals a gap on the theoretical discussions relating to financial administration of multinational companies. This paper explores the causes of research gaps on financial management of multinational companies and explains why discussions on the same topic have so far fell on unfertile ground. The paper argues that existing financial paradigms are inadequate to the phenomenon of the multinational companies. Additionally, the paper discusses the influence of different features of internationalized markets on the cost of capital of multinational companies. According to Adler, in its simplest form, a multinational company is a parent company that has at least one subsidiary abroad (Adler 1973). Conversely, when debating financial challenges of multinational companies, most scholars normally assume that there are at least two affiliates abroad and the parent company at home forming the multinational company (Etienne 1977). From a legal perspective, most multinational subsidiaries are independent companies (Kuemmerle 2005). On the other hand, from an ownership viewpoint multinational subsidiaries link directly or through an intermediate subsidiary to the parent company (Choi 1981). Therefore, multinational companies are an amalgamation of companies led by the parent company and connected by shareholdings between the companies. Background on Cost of Capital A firm’s capital structure consists of debt and equity (Buttler 2012). The cost of retained earnings mirrors an opportunity cost, which is what shareholders would have earned if they received dividends and invested themselves. Firms’ cost of issuing new stock also mirrors an opportunity cost, which are the foregone earnings that shareholders would have earned by investing elsewhere other than in the stock (Berk 2007). The cost of issuing new stock exceeds the cost of retained earnings as it includes other expenses related to selling the new stock (Butler 2012). Measuring the cost of debt of a firm is easy because the firm incurs interest expenses when borrowing funds (Hitt 2004). Firms try to mix capital components that minimize the cost of capital. A firm with a lower cost of capital will have a lower required rate of return on a given project (Mignolet 2011). Generally, firms approximate their cost of capital before capital budgeting because the net present value of projects partially depends on the cost of capital (Shapiro 2010). Cost of Equity Vs Cost of Debt It is advantageous to use debt rather than equity because interest payments on debt are tax deductible (Birkinshaw 2003). However, using greater debts would lead to greater interest expenses increasing the likelihood of the firm being unable to meet its expenses. Subsequently, the rate of return required by potential creditors or new shareholders will increase reflecting a higher prospect of bankruptcy (Shapiro 2010). There is a trade-off between tax deductibility of interest payments and increased prospect of bankruptcy (Avarmaa). A firm’s cost of capital primarily decreases as the ratio of debt to total capital increases. However, at a given point, the cost of capital increases as the ratio of debt to total capital rises (Eiteman & Stonehill 2013). This puts forward that the firm should escalate its use of debt financing up to the point where the bankruptcy prospect turn out to be large enough to compensate the tax advantage of using debt. Beyond this point, the firm’s overall cost of capital would increase (Shapiro 2010). Multinational Cost of Capital Size of Multinational Company Multinational companies that often borrow large amounts may have special treatment from creditors, in so doing reducing its cost of capital. Additionally, its comparatively large issues of bonds or stocks allow for lower flotation costs compared to the amount of financing. These benefits are due to the size of multinational companies and domestic firms that are large enough might receive same treatment. Multinational companies can more easily achieve growth and therefore, are more able to reach the needed size to be recipients of preferential treatment from creditors (Ross & California 1998). Access to International Capital Markets Multinational companies are usually able to accumulate funds from the international capital markets. Because the cost of capital varies across markets, accessibility of international markets allows multinational to source funds at a lower cost (Lee 1986). Coca-Cola Company’s recent annual report states that, “Our global presence and strong capital position afford us easy access to key financial markets around the world, enabling us to raise funds with a low effective cost.” International diversification The probability that a firm will go bankrupt affects its cost of capital. Since multinational company’s cash inflows come from sources around the world, the inflows are more stable as no single economy highly influences the total sales. Because individual economies are autonomous, net cash flows from a group of subsidiaries may reveal less variability reducing the probability of bankruptcy and ultimately the cost of capital (Berk 2007). Exposure to exchange rate risk The cash flows of a multinational company could be more volatile if it is exposed to exchange rate risk (Mignolet 2011). For instance, if foreign earnings are remitted to the U.K parent company, they earnings would not be worth as much when the sterling pound is strong than other major currencies. Therefore, the ability to make interest payments on outstanding debt reduces, and the probability of bankruptcy increases. This scenario could force shareholders and creditors to call for higher returns increasing the cost of capital for multinational companies. Generally, a firm that is more exposed to volatile exchange rate will typically have a wider distribution of probable cash flows in future periods. Because the cost of capital should replicate that prospect, and the probability of bankruptcy increases with uncertainty of expected cash flows, exposure to volatile exchange rates could lead to a higher cost of capital (Zenoff 1980). Exposure to country risk A multinational company that launches foreign subsidiaries is subject to the likelihood that the host nation government may grab a subsidiary’s assets (Brooke & Remmers 1978). Many factors influence the prospect of such an incidence. Such factors include the approach of the host country government and the associated industry. The probability of a multinational company going bankrupt increases if there is no compensation for the seizure of its assets. The greater the percentage of a multinational’s assets invested abroad and the greater the risk of operation in the countries, the higher the cost of capital and the probability of the multinational company going bankrupt (Baker 2011). Other components of a country’s risk such as new tax laws could also affect the cash flows of a multinational subsidiary. These country risks are not essentially merged into the cash flow projections as there occurrence is unpredictable. Nonetheless, there is a probability that the events will occur and therefore, the capital budgeting process should include such risks. Multinational Companies in the Modigliani/Miller Structure The incorporation of the phenomenon of multinational companies into the Modigliani/Miller structure was attempted mainly 1970’s. The capital structure of multinational companies is important for valuation. The existence of repatriation and exchange rate risks leads to the annulment of the M/M-theorem (Krainer 1972). However, the major challenge of Krainer’s work is the assumption that the presence of worldwide corporate income taxes lead to similar implications, (Etienne 1977). Regardless of heated debates following Krainers paper, models founded on the M/M-structure discussing financial aspects of multinational companies grew out of fashion. This is supported by the fact that attempts to embed multinational companies into the M/M-structure did not go beyond mid 1970’s. The meltdown of efforts to incorporate multinational companies into the M/M structure is no surprise as a comparison of the methodological ground the theoretical rationale of the multinational companies reveals. The Modigliani and Miller capital structure theory is similar to the perfect-market model, where assumptions such as transaction costs, market transparency and absence of taxes exist (Modigliani & Miller 1958). In this model, the market will always attain an equilibrium position and any differences are normalized as soon as they emerge. Analysis of the equilibrium states is the core focus of the research rationality based on this structure. Conversely, international management works see a multinational company as an organizational phenomenon that whose existence is attributable to the occurrence of market imperfections such as international segmentation of national markets (Buckley & Casson 1976). In a perfect market environment, multinational companies would never form due to lack of market imperfections to exploit. From the perspective of a perfect market-paradigm, multinational company is therefore, an anomaly that has no explanation. Financial Contracting Capital Framework Approaches Scientific progress has seen the substitution of the M/M framework of capital structure with approaches founded on financial contracting-theory framework. These approaches describe the significance of a firms capital structure in relation to features such as information asymmetry between capital markets and insiders or basing on agency relationships between stakeholders of the firm (Cackowski 1982). However, regardless of the wide range of financial theories founded on the financial contracting context, a transformation of the theories to the multinational companies’ incident is rare in the literature. Multinational companies are inadequately cited in these models and in methodologies based on them. This opens a window for interpretations. Either, the scholars and researchers are making implicit assumptions that the results of their analysis can be transformed to the multinational case without challenges or they are deliberately limiting analysis to the national case (Buckley & Enderwick 1979). This leaves a real train of thought concerning analysis built on the financial contracting-theory framework. Capital Structure Ambiguities From a financial viewpoint, a multinational company consists of a set of different units, each presenting a unique capital structure. Furthermore, relying on national accounting guidelines, the parent company is obliged to set up a combined statement for the multinational company as a whole. The combined statements comprise a consolidated capital structure. Therefore, the capital structures of legally autonomous companies inter-connect through an accumulated capital structure (Lee 1986). The relevance and function of the consolidated statements vary between nations due to different national accounting principles. Consequently, venture capitalists from different nations may understand financial information from consolidated capital structure of a multinational company differently (Choi 1981). Conclusion When evaluating the risk of loaning to entities of a multinational group, an investor cannot be sure of the capital structure to use in evaluating the risk of default. For instance, a financial institution that lends funds to a subsidiary is not sure if the parent company would allow the subsidiary to default on its debt unless it guarantees the debt (Holzer 1986). Similarly, shareholders of the parent company may face problems such as evaluation of the parent company leverage with respect to the consolidated group’s leverage. This ambiguity, which arises from divergence of legal separation and economic unity, is a feature that financial contracting based capital structure theories fail to cover. While theorists agree that a firm’s capital structure is a signal that investors can use to reduce uncertainty, choosing a capital structure to use in measuring risk remains a problem for investors (Gatignon & Anderson 1987). Neither the financial contracting nor the M/M framework approaches are the appropriate playground to syndicate capital structure considerations with the multinational companies’ phenomenon. The M/M approach is clearly discordant to the phenomenon of the multinational companies. On the other hand, approaches founded on financial contracting theories ignore important details of the multinational companies such as stakeholders improbability about the suitable capital structure for assessing the risk of their stake. References Adler, M. (1973). The cost of capital and valuation of a two-country firm. New York: Graduate School of Business.Top of FormBottom of Form Avarmaa, M., & Hazak, A. (n.d.). Capital structure formation in multinational and local companies in the Baltic States.Top of FormBottom of Form Baker, H. (2011). Capital structure & corporate financing decisions theory, evidence, and practice. Hoboken, N.J.: John Wiley & SonsTop of Form.Bottom of Form Baker, J. (n.d.). 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